Do capital market banks deserve more investor respect?

While acknowledging the challenges, Financials Global Sector Specialist, Chris Costanza, sees a disconnect between sentiment and fundamentals, providing investors with an attractive risk-reward skew in the systemic banks.

02/11/2015

Chris Costanza

Global Sector Specialist (Financials)

Banks make tangible progress

Despite dramatic improvements in capital levels, liquidity, and asset quality, large capital market banks (i.e., brokers and money centre banks) trade at half their pre-crisis levels on a price-to-tangible book basis. Are investors correctly evaluating the risk and reward or do they remain anchored in crisis-era thinking?

Preparing for the quarterly earnings season, I was recently reminded of just how far the large global banks have come in terms of safety and soundness.

To be sure, the US has led the charge, but Europe is doing its best to catch up and adapt as well.

Despite this, the global banks are broadly trading at approximately half their pre-crisis valuation levels on a price-to-tangible-book basis. In our view, this presents an opportunity.

Pre-crisis: Picking up quarters in front of a steamroller

Prior to 2008, I would argue that owning brokers and money centre banks left investors exposed to catastrophe risk.

Nine out of ten years, investors collected premiums in the form of healthy book value growth.

However, leverage, illiquid asset build-up, and flawed funding structures meant that investors were constantly at risk of dilution or permanent loss.

Despite this, these global banks traded between 1.5 times to 2.5 times (or more) tangible book value.

Fast forward: What a difference seven years make

We believe today’s investors in capital market banks are exposed to a more favourable return profile.

Why the change in view? Regulators, rating agencies, and politicians have forced significant change within systemic banks. Key aspects of this change include:

More capital: Banks are holding a lot more capital. On a simple capital-to-assets view, equity has more than doubled versus 2007

More liquidity: Bank liquidity is many times higher than in 2007. Furthermore, funding stability has increased significantly. These changes are due, in large part, to rules such as the liquidity coverage ratio (LCR), net stable funding ratio (NSFR), and total loss-absorbing capital (TLAC/MREL – pending final rules)

Reduced trading inventory and illiquid assets: The prohibition of proprietary trading and changes in risk-weighting methodology have caused trading inventory to fall by more than 50% and Level 3 (illiquid assets) to fall by more than 60% on broker balance sheets. While this may well be leading to liquidity and volatility issues outside the banks themselves (i.e. with asset managers and other buyside participants), the brokers are undeniably more robust against market stress

Reduced counterparty risk: Given the importance of bank counterparty risk, the improvement of all major trading partners should not be underestimated. In other words, the system is as strong as the weakest link. Regulators are also enforcing counterparty limits and central clearing of most over-the-counter derivatives, reinforcing market structure

Regular exams: Regular stress tests reduce the likelihood of risk build-up and keep both regulators and bank executives attuned and engaged with one another. These tests continue to become more thorough and difficult as time goes on due to the layering of stresses, providing further comfort on bank durability.

Better structure, higher returns?

The underlying structure of the industry is improving and should continue to do so.

Market share is consolidating, with banks in Europe, in particular, shifting away from the most capital intensive market-making business lines; there is anecdotal evidence of improved pricing, the litigation peak appears to have been reached for most banks, and the end of re-regulation appears to be in clear sight.

There is also a structural growth story outside the US: while 80% of US non-financial borrowing takes place in the capital markets, Europe sees the reverse, with 80% of borrowing happening on bank balance sheets.

Given an increased focus on bank balance sheet efficiency, Europe’s bond market will likely increase significantly over the next decade, with Asia not far behind.

Why aren’t banks better loved?

Despite the aforementioned improvements, many of these companies traded at current price levels, or higher, as far back as mid-2009.

Why? Well, for one, regulation is much tougher than what was imagined six years ago. Further, litigation expense has bled $200 billion and counting of shareholder funds.

Finally, unprecedented central bank involvement in markets has depressed both rates and volatility across major markets, reducing client activity levels and bank revenue.

I would characterise the above as reasonable reasons for less-than-stellar returns.

But, there also appears to be aspects of valuation that are being driven more by sentiment and fear than by fundamentals.

The logic seems to go as follows: Capital markets were the epicentre of the last crisis; therefore, any time there’s a whiff of stress (i.e. housing bubbles, European dis-union, China wobbles), sell the global systemic banks.

Investors should consider taking advantage of the disconnect between sentiment and reality.

I’m very aware of the danger in prognosticating on complex, global banks. After all, the next global crisis or scandal may be just around the corner.

Furthermore, some European banks still have ground to cover before reaching their capital and liquidity end state.

However, looking at the sector broadly, I see strength, stability, and constructive industry dynamics.

If correct, this should result in a significant re-rating in addition to dividends, buybacks, and book value growth while investors wait.

The information on this website is intended solely for use by Singapore residents.

The funds mentioned are Singapore- authorised and recognised funds registered for sale or purchase in Singapore. By proceeding you are representing and warranting that you are either resident in Singapore or the applicable laws and regulations of your jurisdiction allow you to access the information. In particular, the information is not for distribution and does not constitute an offer to sell or the solicitation of an offer to buy units in Schroder funds in any jurisdiction where such activity is prohibited including the United States of America.

The contents on this website are for information only and without consideration given to the specific investment objective, financial situation and particular needs of any specific person. You may wish to seek advice from a financial advisor before purchasing units of any Schroder fund. In the event that you choose not to seek advice from a financial advisor before investing in any fund, you should consider whether the fund selected is suitable for you.

Past performance and any forecasts are not necessarily indicative of future performance. The value of units and the income from them may fall as well as rise. The funds are subject to investment risks. You should read the relevant prospectus obtainable from this website before investing.

The material and information on this site is current at the date of publication and is provided on an "AS IS" basis and without without any warranties of any kind, either expressed or implied.

To the best of the knowledge, information and belief of Schroder Investment Management (Singapore) Ltd ("SIMSL"), all information contained herein is accurate as at the date of publication. However, SIMSL or its affiliates or any director or employee of SIMSL or its affiliates cannot and does not warrant, guarantee or represent, either expressly or by implication, the accuracy, validity or completeness of such information.

Under no circumstances may the information contained herein, or any part thereof, be copied, reproduced or redistributed without the express permission of SIMSL. SIMSL or its affiliates, any directors or employees of SIMSL or its affiliates shall not be liable for any damages arising from any person's reliance on such information and shall not be liable for any errors or omissions (including but not limited to errors or omissions made by third parties) in such information. The information provided herein is subject to change without further notice.

Schroder Investment Management (Singapore) Ltd is regulated by the Monetary Authority of Singapore and is a member of the Investment Management Association of Singapore (IMAS).

We use cookies to help improve your experience with this website. By using this site, you agree that we may store and access cookies on your device. Cookies are small text files, downloaded onto your device, that tell us which pages you've visited, when and what your technology preferences are. To find out more about the cookies that we use, their purpose and how you can manage them, please visit: How we use Cookies

MSCI Disclaimer

Source: MSCIThe information obtained from MSCI and other data providers, included in reports available from this website, may only be used for your internal use, may not be reproduced or re-disseminated in any form and may not be used to create any financial instruments or products or any indices. The MSCI information and that of other data providers is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling or creating any MSCI information (collectively, the “MSCI Parties”) and other data providers, expressly disclaim all warranties (including, without limitation any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party or other data provider have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages.